Shareholder dilution - Does size still matter?

Posted by Chris on July 09, 2012

Share schemes are great motivation tools when the level of reward on offer is right, but how can you establish what the right amount is?

As a director or shareholder, you need to be careful that you are not offering too little equity for an employee to be incentivised (hence wasting equity), or offering too much and being wasteful. Some of our clients come to us and already have clear views on the size of awards they wish to make and others need help in exploring this matter further. Some key considerations to bear in mind are:

A share scheme should incentivise employees to go the extra mile and ensure their options/shares in the Company achieve not only the reward that you have said is probable, but also what they think is possible (i.e. it stretches performance to exceed expectations). It is important that it delivers the right reward to plan participants but also essential that it enhances value for the existing stakeholders in the business. This article therefore builds on our earlier review of the initial considerations behind determining the quantum of any employee equity pool and highlights some additional factors and recent developments that can further influence the decision about the size of awards.

Our experience and recent developments

Over the years we have found that the typical range of equity that our entrepreneurial clients offer to their employees is between 5 - 25% of total share capital. Often the decision is driven by whether the awards are for select individuals or more widely offered to all employees and whether there is anti-dilution pressure from major external investors. For those with higher percentages we are looking at companies that offer some form of equity incentive to all employees. There is also now an emerging trend, backed by political support from the likes of Nick Clegg and Norman Lamb, for complete transition to 100% employee ownership and those business owners that feel an affinity to the models of ownership that involve a full transition will find more information here.

Key things to look out for when deciding on the level of equity participation for employees are:

Employee Expectation

One reason that equity can be offered is as compensation for below market rate salaries. Few companies have offered above inflation salary rises and many have instigated pay freezes or cuts during the recession. If this is the case, then you must factor in what salary could they expect elsewhere or how much of the award employees might view as reward for just doing their normal job and then offer enough equity to compensate for the salary gap and provide a future on-going incentive. Salary also needs to be taken into account in order to calculate what sum of money on an exit event is going to be meaningful to that employee. If the realisation of cash is not in the next 3 - 5 years the expected reward must be big enough to make them stay with the Company for that period of time.

Entrepreneurs' Relief (ER)

In order to achieve ER (and thereby benefit from a relief that reduces the effective rate of CGT payable on any gain from 28% to 10%) an individual (who must be an officer or employee of the Company) must acquire 5% of the voting share capital and hold those shares for one year prior to a sale/disposal of those shares. We have previously explained that the more tax efficient the incentive then the less equity needs to be offered to achieve the same net gain. Forthcoming changes to the interaction of ER and one of the most popular share option plans, the Enterprise Management Incentive (EMI), mean that existing awards might, with no further action by the Company, deliver an even bigger incentive for employees and for new awards mean that less equity will be needed in future to provide the desired net gain.

Dilution impact and management

When you award options and the employees exercise them to become shareholders, the simplest and most common route for shares to be delivered to the employees is by an allotment of new issue shares from the Company. If this is the case, then all shareholders are equally diluted. For any shareholder hovering around the 5% shareholding interest, this dilution can be the difference between them achieving a 10% tax rate (with Entrepreneurs' Relief) or a 28% capital gains tax (once diluted below 5%). As soon as the shareholder drops below 5%, one of the criteria for Entrepreneurs' Relief is not met and they no longer qualify. Another concern can be anti-dilution pressure from external investors. The often maligned Employee Benefit Trust (EBT) can serve a very useful and valid purpose in managing such dilution challenges as the trust can be used, in conjunction with an approved share plan, to purchase shares from existing shareholders and, in effect, recycle the issued share capital and thus avoid any need to issue diluting new shares.

New guidance concerning on the date of sale

What happens if you have shareholders hovering around the 5% shareholding and on a sale of the business there are options that are to be exercised? In this case, the 5% shareholder would have held the shares right up to the point of the sale; however, as soon as the options are exercised the shareholding is no longer 5%. This matter concerns the requirement (in s. 168I (6) TCGA 1992) for the 5% interest to be maintained continuously for 1 year ending with the day of sale.

A strict reading of the legislation therefore implies that the existing shareholder has failed the test for ER on that very last day. As such, prudent advisers have hitherto advised clients to model any dilution impact taking into account any option exercises that might occur on the day of sale.

However, in what must be stressed is informal guidance, HMRC have responded to the Chartered Institute of Tax (CIOT) who raised queries about this and consequently, in January 2012, CIOT issued summary guidance to its members which states that HMRC would, in such circumstances, still treat the 5% shareholder as eligible for ER despite the on the day of sale dilution provided they had met all other conditions for ER.

How our modelling services can help

It is important to remember that employees and shareholders are not really interested in how many shares they have or may have, or necessarily what percentage interest they hold. The focus of their attention will be what is the potential return on their investment? In determining their reward you should therefore first consider what is their projected net gain? (i.e. their spending power after tax) and ask is this enough? RM2 offer a spread sheet modelling service which examines what the primary shareholders are hoping to achieve as a sale price for the business on any exit, what they are hoping (or need to be able) to take as a net gain and consequently calculate an appropriate equity pool for employees ensuring this is delivered as efficiently as possible to optimise rewards for all shareholders. The spread sheet can then be used to model potential outcomes by flexing exit values, equity amounts and dilution, option exercise prices and tax rates to find an optimised position. We then consider not only existing employees and imminent awards but also work with clients to ensure this is, as far as possible, future proofed. It is important that you do not give too much away early on and retain sufficient capacity to accommodate additional awards if your business plan includes headcount increases and key hires in the future.

We offer a modelling service which considers;

The goals of primary shareholders on an exit.

What the recommended available pool to offer employees would be.

Whether individual proposed awards are adequate.

Plans for existing employees and future employees.

The impact exercising options has on all shareholders.

If you would like any further information on our modelling service please call the team on 020 8949 5522 and they will put you through to an advisor who can help.